What to Consider Before Refinancing Small Business Debt

Eventually, there comes a time when small business owners set their sights on growth and expansion. Doing so often requires more capital, and many small business owners consider replacing their existing business debt with a new, more affordable loan. This process is called refinancing and can be a critical step to grow your business.

When done correctly, refinancing your business debt can lower your monthly payments, APR, and interest payments, improve your overall credit score, and most importantly, free up cash flow to invest back into the business.

Once you’ve made the decision to refinance your business debt, consider the following questions before you reach out to a lender and start the application process:

1. What are lenders looking for when analyzing your business’s financial performance?

Lenders will request your tax returns and your interim financials when considering your business for refinancing. Before applying, make sure you have all of your business financials prepared so that lenders can analyze the financial position of your business and get a full understanding of its historical performance. Lenders will request the following:

Corporate tax returns (3 years)

Personal tax returns (3 years)

The interim profit and loss statement

The interim balance sheet statement

Once the financials are submitted, the lender will be able to analyze the business’s EBIDA, or earnings (net income or loss) before interest, depreciation and amortization. EBIDA is calculated with the following formula: net profit + interest + depreciation + amortization. This metric helps lenders gauge if your business has the capacity to pay back monthly payments. Let’s look at an example of how EBIDA is calculated:

2. What is your business’s current level of debt since the original loan was made?

Lenders want to know what the debt service coverage ratio (DSCR) is for your company, or the ratio of cash your business needs to make the yearly payments to interest and principal on the debt acquired for a particular period.This ratio is used to determine the business’s solvency or the ability to pay off debt. DSCR is calculated by: net operating income / annual debt obligation. Follow the example below to find these figures:

Review all your existing business debt and its terms. Before reaching out to a lender, consider creating a chart like the one shown below that clearly details all the information required to find the monthly and yearly payments on your debt.

In the example above, the annual debt service is $6,708. Annual debt service is calculated by adding together the monthly principal and interest payments and multiplying the sum by 12. Once you have your total annual payments or debt service, compare this number to your business’s EBIDA. Using the example above, the EBIDA is $6,000.With these two figures, you’ll be able to calculate your DSCR. The formula for DSCR is: DSCR = EBIDA/DS

Let’s use our example to determine the DSCR:

Your DSCR needs to be equal or greater than 1. In our example, the ratio is lower than 1, and as such, the company does not have enough money to make the yearly payments of $6,708.

In this case, the business could benefit from refinancing its current debt by obtaining a loan at a lower interest rate and lower monthly payments. To refinance the existing debt follow this formula: current balance owed + any additional capital + origination fee.

It’s important to note that origination fees — fees charged upfront by a lender to ensure an applicant’s commitment and offset some of the processing costs — may vary between lenders. Typically, these fees are stated as a percentage of loans.

Let’s look at an example:

The monthly payments on an $11,450 loan, with an interest rate at 10.0% and 3 year term would be $370.21, or $4,442 annually. Let’s see if the DSCR improves in this case:

A DSCR of 1.3 is a satisfactory ratio for a lender and this request to refinance would be approved.

Additional Questions to Ask New Lenders:

Terms and conditions of loans can vary between lenders. As a best practice, ask the following questions to the new lender. The information you gather from these questions can highlight whether or not a lender is transparent and trustworthy:

Is the loan short term or long term?

What is the closing fee?

Is the interest rate fixed or variable?

Is there a prepayment penalty?

A refinance should cover loans that have daily/weekly payments, merchant cash advances, factoring, high interest rates and short term debt. Refinancing your business debt only makes sense if it provides better terms and benefits to the overall financial health of your business, so make sure to do your math before you start the conversation with the lender.

If you are looking to refinance your existing business debt with a more affordable loan, contact an EGF advisor at 1-866-466-9232.

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Excelsior Growth Fund (EGF) promotes economic development and job creation in New Jersey, New York and Pennsylvania by providing streamlined access to small business loans and business advisory services. Excelsior Growth Fund is a not-for-profit 501(c)(3) and certified by the U.S. Department of Treasury as a Community Development Financial Institution (CDFI).